Tokenization: An Alternative Way of Raising Funds for Start-ups

Most funding for startups looks for the next big thing. The reality of startups is that most may fail and those that survive will not necessarily become unicorns. This means traditional fundraising process requires significantly more effort, time, and money. Tokens provide fundraising offers that are best suited for blockchain-related projects and business projects supported by stakeholder capitalism (with a priority interest of all stakeholders, including shareholders, employees, customers, suppliers, communities, and the environment).

What is Tokenization?

Tokenization is the process of replacing sensitive data with unique identification symbols that retain all the essential information about the data without compromising its security. Tokenization, which seeks to minimize the amount of data a business needs to keep on hand, has become a popular way for small and midsize businesses to bolster the security of credit card and e-commerce transactions while minimizing the cost and complexity of compliance with industry standards and government regulations.

We are however interested in its application for funding for startups. So we can redefine Tokenization as the process of representing a physical or intangible asset as a digital token on a blockchain. It allows the asset to be sold or traded in the form of a token, rather than as a traditional financial instrument such as stock or a bond.

As traditional fundraising can be slow and costly, particularly for entrepreneurs without existing investor networks, an alternative source of funding for dApps has emerged: Cryptocurrency Fundraising (also known as Token Fundraising), where the project owners offer its dApp project’s tokens to interested investors at a relatively discounted price in order to raise funds to run their business.

A History of Traditional Fundraising

In the traditional finance textbook, there are two primary sources of funding: debt and equity. Companies can raise debt funding by asking a bank for a loan or issuing corporate bonds. Equity fundraising offers a different set of options. Companies can bootstrap, ask friends and family for small investments, or raise funding from private investors.

Blockchain through Decentralized Applications (dApps), which are web services that use blockchain as a base infrastructure, provide community solutions such as financial services, referred to as Decentralized Finance (Defi). In normal cases, the trustworthiness of the dApp project (also referred to as dApp protocols) will depend heavily on the project roadmap, the code presented, and the owners’ background. However, dApp projects do not need to be registered companies and the project owners can be anonymous.

History of tokenization

Tokenization has existed since the beginning of currency systems, in which coin tokens have been used as a replacement for actual coins and banknotes. Subway tokens and casino tokens are two examples, as they serve as substitutes for actual money. Physical tokenization is the same as digital tokenization – creating a surrogate for a more valuable asset.

Digital tokenization saw use as early as the 1970s. In the databases of the time, it was used to separate certain sensitive data from other data being stored.

More recently, tokenization was used in the payment card industry as a way to protect sensitive cardholder data and comply with industry standards. The organization Trust Commerce is credited with creating the concept of tokenization to protect payment card data in 2001.

How it works/Ways of Tokenization

One way that start-ups can use tokenization is by issuing tokens that represent ownership in the company. This is known as a security token offering (STO). By issuing security tokens, a start-up can raise funds from investors in a similar way to a traditional initial public offering (IPO), but with the added benefits of increased liquidity and reduced regulatory burdens.

Another way that start-ups can use tokenization is by issuing tokens that represent a specific product or service. For example, a company that sells online courses could issue tokens that represent access to a specific course. These tokens could then be bought or sold on a secondary market.

Tokenization can be an attractive option for start-ups because it allows them to raise funds quickly and easily, without the need for traditional financial intermediaries.

?Token types

Tokenization is the process of creating a digital token or asset that represents ownership of a real-world asset or utility. It can be used as a way for start-ups to raise funds by selling tokens to investors in exchange for capital. There are several different types of tokenization that start-ups can consider, including:

Security tokens: These tokens represent ownership in an asset or company and are subject to federal securities regulations. Security tokens can be used to represent equity, debt, or other financial instruments.

Utility tokens: These tokens grant the holder access to a product or service offered by the issuing company. Utility tokens do not represent an ownership stake in the company and are not subject to the same regulatory requirements as security tokens.

Asset-backed tokens: These tokens represent ownership of a specific physical asset, such as real estate, art, or commodities. Asset-backed tokens can be used to facilitate the buying and selling of the underlying asset.

Stablecoins: These tokens are pegged to the value of a real-world asset, such as the US dollar, and are intended to minimize price volatility. Stablecoins can be used as a medium of exchange or a store of value.

Cryptocurrencies: These are digital assets that use cryptography for secure financial transactions. Examples include Bitcoin and Ethereum.

Non-fungible tokens (NFTs): These tokens represent a unique digital asset, such as a piece of art or a collectible. NFTs are stored on a blockchain and can be bought and sold on a marketplace.

Mechanisms for Tokenization

There are several ways people categorize the types of token fundraising. One of the easiest ways to understand token fundraising is to break it into Private Placements and Public Offerings.

Private Placement

The private placement is a method of raising capital by selling securities to a small group of select investors, rather than through a public offering. Private placements are typically used by companies that are not yet ready or do not want to go through the regulatory requirements and expenses of a public offering.

Token presales, also known as pre-initial coin offerings (pre-ICOs), are a form of private placement in which a startup or project sells tokens to a small group of investors before conducting a public ICO. The goal of a token presale is to raise funds for the project's development and/or business growth.

Investing in a token presale can be risky, as there is no guarantee that the project will be successful or that the tokens will have any value. However, if the project is successful, investors may be able to sell their tokens for a profit when the ICO is launched or when the tokens are listed on exchanges.

It is important for investors to carefully consider the risks and potential rewards of investing in a token presale or private placement, and to thoroughly research the project and its team before making any investment decisions.

Public Offerings

There have been three main types of public offerings.

1)?????Initial Coin Offering (ICO):

An initial coin offering (ICO) is a method of fundraising that involves the sale of tokens to the public. In an ICO, a project creates a whitepaper that outlines the details of the project and the terms of the token sale. This whitepaper serves as the primary source of information for potential investors and is intended to provide transparency and build trust in the project.

During an ICO, the project sells tokens to investors in exchange for cryptocurrency or fiat currency. The tokens are typically utility tokens, which can be used to access and obtain services and products within the project's protocol. They may also be governance tokens, which give the holder the right to vote on the direction of the project.

ICOs have been a popular method of fundraising for cryptocurrency and blockchain projects, but they have also been associated with high levels of risk and fraud. Many projects have raised funds through ICOs but have failed to deliver on the promises made in their whitepapers, leading to the loss of investment for many people. As a result, regulatory bodies in some countries have introduced stricter rules and regulations around ICOs to protect investors.

In response to the risks and regulatory challenges associated with ICOs, two other fundraising methods have emerged: initial exchange offerings (IEOs) and initial DEX offerings (IDOs). IEOs are conducted through a cryptocurrency exchange, which acts as an intermediary between the project and investors. IDOs are conducted on decentralized exchanges (DEXs), which allow for peer-to-peer trading without the need for a centralized intermediary. Both IEOs and IDOs aim to provide greater security and transparency for investors, but they still carry some level of risk.

?2)?????Initial Exchange Offering (IEO):

An initial exchange offering (IEO) is a fundraising method that involves the sale of tokens by a cryptocurrency or blockchain project through a cryptocurrency exchange. In an IEO, the exchange acts as an intermediary between the project and investors and is responsible for evaluating the credibility and viability of the project. This is intended to provide a level of security and transparency for investors, as the exchange is likely to have stricter vetting and due diligence processes in place compared to an ICO.

After a successful IEO, the project pays a listing fee to the exchange and provides a pre-determined number of tokens for the use of the exchange's platform and services. This can provide the project with significant exposure and credibility, as well as access to a large pool of potential investors.

IEOs have become a popular alternative to ICOs, as they offer some level of protection for investors and may be subject to fewer regulatory challenges. However, it is important to note that IEOs still carry some level of risk, and it is important for investors to carefully consider the potential risks and rewards before making any investment decisions. IEOs gave birth to some of the most well-known blockchain projects of today including Polygon and Elron.

3)?????Initial Decentralized Exchange Offering (IDO):

An initial decentralized exchange offering (IDO) is a fundraising method that involves the sale of tokens through a decentralized exchange (DEX). IDOs are similar to initial exchange offerings (IEOs), but they use a DEX instead of a centralized exchange to facilitate the sale of tokens.

IDOs are conducted through an IDO launchpad, which is a platform on a DEX that allows projects to issue and sell their tokens to investors. IDO launchpads are typically automated and run on smart contracts, which are self-executing contracts with the terms of the agreement between buyer and seller being directly written into lines of code.

To participate in an IDO, a project must submit its fundraising proposal to the IDO launchpad. If the project meets the launchpad's standards, which are typically assessed by the launchpad team and the community, the project can issue its tokens on the DEX. These standards usually only cover the project code and whitepaper and do not require the project team to disclose their identities.

IDOs are intended to provide a more decentralized and transparent alternative to ICOs and IEOs, as they use DEXs, which are peer-to-peer exchanges that do not require a centralized intermediary. However, it is important to note that IDOs still carry some level of risk, and it is important for investors to carefully consider the potential risks and rewards before making any investment decisions. The most popular ones include BSC Pad, Polkastarter, DAO Maker, and Solanium.

Examples

NFT Examples

One example of a start-up that has used NFTs to raise funds is Axie Infinity, a blockchain-based game that allows players to breed, raise, and battle fantasy creatures called Axies. The company has sold NFTs representing unique Axies, which can be used in the game and traded on a marketplace.

Another example is CryptoKitties, a blockchain-based game that allows players to breed and trade unique digital cats represented as NFTs. The company has sold NFTs representing unique digital cats, which can be used in the game and traded on a marketplace.

Security Token Examples

One example of a start-up that has used security tokens to raise funds is tZERO, a blockchain-based platform for trading security tokens. The company raised over $250 million in a security token offering (STO) in 2018.

Another example is Aspen Digital, a real estate company that used security tokens to sell fractional ownership in a luxury hotel in Aspen, Colorado. The company raised over $18 million in a security token offering in 2019.

Utility Tokens Examples

One example of a start-up that has used utility tokens to raise funds is Filecoin, a decentralized storage network that allows users to rent out unused hard drive space. The company raised over $257 million in a utility token offering (UTO) in 2017.

Another example is EOS, a blockchain-based platform for developing decentralized applications. The company raised over $4 billion in a utility token offering in 2018.

Asset-Backed Tokens Examples

One example of a start-up that has used asset-backed tokens to raise funds is RealT, a platform for buying and selling fractional ownership in real estate using blockchain technology. The company has used asset-backed tokens to facilitate the buying and selling of real estate assets.

Another example is ArtChain Global, a platform for buying and selling art using blockchain technology. The company has used asset-backed tokens to represent ownership of specific artworks and facilitate the buying and selling of art on its platform.

Stablecoins Examples

One example of a start-up that has used stablecoins to raise funds is Circle, a peer-to-peer payment platform that has issued a stablecoin called USDC. The company has used USDC as a medium of exchange and store of value and has raised funding through the sale of USDC to investors.

Another example is MakerDAO, a decentralized finance platform that has issued a stablecoin called DAI. The company has used DAI as a medium of exchange and store of value and has raised funding through the sale of DAI to investors.

?What Type of Fundraising Method is Suitable for Startups?

Blockchain startups and projects should perform token fundraising via private placement since the companies can gain instant funding and other benefits from investors without giving up ownership or voting rights. The token fundraising process is also substantially more efficient in terms of cost and time since the companies do not need to pay for investment bankers' fees or spend time restructuring the organization and preparing tremendous documentation as required for the traditional IPO. The company or project owner can approach several angel investors or institutional investors to gain advantages such as increasing the project’s credibility, providing operational support, or helping the company grow its network and ultimately developing a concrete protocol. By taking these actions in the private placement stage, the company or project owner can later execute an IEO/IDO at a higher price compared to the presale round or raise funds via traditional debt or equity as needed. In general, it is still not recommended for dApp startups to execute an ICO, as ICOs are less credible and more costly compared to IEO/IDO. Low credibility and lack of investor awareness could prevent startups from raising sufficient funding. Thus, ICOs require the projects to pay a significantly large sum of marketing budget to build their trustworthiness and raise funding awareness, whereas IEO/IDO can utilize their credibility and existing customer base nearly at no cost. For instance, Chainlink is a decentralized oracle network that allows smart contracts to access off-chain data. The company raised over $32 million in its ICO in 2017. The company used the ICO portal provider CoinList to assist with the launch of its ICO.

Further, startups should be wary of raising funds via both equity and token, since it may create a conflict of interest between equity holders and token holders. This conflict of interest occurs since the causes of appreciation of equity and token are completely different. The appreciation of equity value is subject to generated cash flow and the expected growth of the company. On the other side, the appreciation of token value is tied to the pure demand for the token. To illustrate, there might be a case where a token holder attempts to convince the company to spend an unreasonably expensive investment just to increase the traffic and demand for the token. Thus, to remove this conflict of interest, a dApp startup should either raise funds via token or equity. Otherwise, it needs to manage the majority of the investors to hold equal amounts of tokens and equity.

?What Type of Fundraising Method Is Suitable for Investors?

In general, dApp startups want funding from institutional investors, as these investors can offer a business instant credibility, operational support, and extended connections. This equips the institutional investor with high negotiating power. Thus, institutional investors who believe in the roadmap of a project and its team should invest in private placements to maximize financial return, as tokens are offered at a discount price. Retail investors are usually unable to access private rounds unless they have a good network with the project owner, but may still find the upside in investing via IEOs or IDOs.

Token investments provide a crucial benefit to angels and institutional investors who invested in the private round: the ability to turn over cash flow. Unlike an equity investment, which requires an extensive holding period, token investments allow early-stage investors to exit at a significantly shorter investment horizon since pushing a project through IEO and IDO, where these investors unload their token to realize their profit, is considerably easier and thus faster than traditional equity IPO. In addition, the token can be staked, during the holding period to gain more return along with, of course, risk. These benefits allow the investors to realize their profit quicker and manage their limited cash flow more flexibly.

Regulation and Supporting Services

Equity and token fundraising will continue to co-exist in the future since the causes of capital appreciation are different. Token fundraising grants dApp projects, as well as traditional companies, a new source of capital; faster, cheaper, and more flexible than ever before. IEOs and IDOs have emerged to mitigate many of the problems seen in the ICO market, and in the future, will co-exist as an alternative funding method alongside traditional fundraising. However, the traditional ICO method will continue to lose popularity and shift to a credibility-upgraded version, the ICO portal. Further, the development of the token fundraising market is not yet mature; new methods may continue to emerge and be further developed, including the use of NFTs for fundraising and the tokenization of real-world assets.

Loan Provider

In a similar fashion to how financial institutions provide lending to traditional small businesses, financial institutions can provide financing to registered dApp startups or individuals who want to create their dApp projects. Financial institutions have much financial and business expertise where most of the dApp projects are running their business. This could include business loans, project financing, or even sponsorship of activities such as gaming, in exchange for interest and/or other types of dApp incentives.

ICO Portal Provider

One of the major weaknesses of ICO and IDO is the lack of trustworthiness. Financial institutions have credibility in the eyes of consumers and could create their own ICO portal to act as a lead underwriter for any token fundraising projects. In addition, there is a growing trend where regulated firms wish to initiate project financing by raising funds via the token. For example, Filecoin is a decentralized storage platform that raised over $257 million in its ICO in 2017. The company used the ICO portal provider CoinList to assist with the launch of its ICO.

Polkadot is a decentralized network that aims to enable interoperability between different blockchain platforms. The company raised over $144 million in its ICO in 2017. The company used the ICO portal provider Web3 Foundation to assist with the launch of its ICO. The utility tokens not only provide monetary returns to token holders but also provide special privileges, such as the right to attend use the service at a discount and any special souvenirs.

KYC Information Provider

When regulations mature, regulators may begin forcing registered dApp startups to KYC their users, this is key, especially in the fight against money laundering. Since financial institutions have extensive customer data and expertise, they can help dApps comply with AML (Anti Money Laundering) regulations by acting as an information provider or consultant for startups to conduct KYC and onboard customers who want to use dApp service.

Regulation

it is important to note that tokenization is still a relatively new and emerging field, and it is subject to various regulatory and legal considerations. As such, it is important for start-ups to carefully consider the legal and regulatory implications of issuing tokens before proceeding with a tokenization project. This is true for both investors and start-up owners.

Fabian Owuor

Web3 Research Hub

#unitmasters

Unit Masters Cohort 13

References:

https://www.techtarget.com/searchsecurity/definition/tokenization